Proposed Draft Legislation on VIE Structures

Posted by CHEONG Wen Quan, Year 2 undergrad at the School of Business, Singapore Management University

Brief Summary

VIE structures are used by foreign companies to circumvent the ban on foreign ownership of sensitive Chinese assets. However, the Chinese Ministry of Commerce recently revealed a draft legislation that could change the way how Chinese regulators look at VIE structures. The main change focuses on who has control over the VIE rather than ‘ownership’. Eg. A VIE will be deemed to be foreign if foreign investors are in control (eg. >50% voting power) over the assets of the respective restricted sectors. Therefore, enough proof must be given to show that Chinese individuals or corporations have a majority control over the VIE, if not they will still be treated as foreign companies. The proposed rules may help reduce uncertainties for companies using the VIE structure as the foreign investors can now directly own parts of the Chinese assets.

Personal View

If this is passed, foreign investors may want to move out of a VIE structure. However, under the current VIE structure, Chinese individuals/owners technically own 100% of the assets in the VIE and are only bounded by contractual agreements between the foreign investors and themselves. Will the reluctance to give up this ownership act as an incentive and a catalyst for a sudden new wave of frauds to occur?

How China’s New Foreign Investment Rules Might Play OutChina’s Ministry of Commerce this week unveiled a draft legislation that could change how the government is regulating a corporate structure that has allowed companies in sensitive industries like the Internet, telecommunications and education to court foreign shareholders. Under the draft, it could bring changes to the way the government regulates foreign investments especially as it pertains to variable interest entity structures, widely used by some of China’s Internet giants. Here are some things you need to know:

What are the rules for foreign investment now?

Under current rules, foreign investors can’t invest directly in Chinese companies that operate in sensitive industries such as the Internet, education and telecommunications. Many companies get around this rule by setting up two entities, an operating company based in China and a holding company based abroad. Foreigners invest in the overseas company and have no direct stake in the Chinese entity, thus skirting the ban on foreign ownership. Instead, the Chinese entity signs contracts that give the overseas company effective control. This structure, called a variable interest entity, or VIE, is used by companies from e-commerce behemoth Alibaba Group Holding to online games giant Tencent Holdings. Until now, the Chinese government has largely turned a blind eye to VIEs, but some foreign investors worry that their status remains unclear.
How will things change under the new law that’s being proposed?

The draft law for the first time addresses VIEs, and it takes a different approach to determining whether a company in a sensitive industry is subject to foreign investment rules. Instead of looking at ownership, it focuses on who has control of the company. It appears to say that VIEs will be deemed to be foreign if foreign investors are in control, meaning they may be barred from operating in restricted sectors, according to Paul Gillis, a professor at Peking University’s Guanghua School of Management. If the VIEs can prove Chinese individuals or corporations are in control, they could be treated as domestic companies, he says.
How is it decided if Chinese or foreigners are in control?

Some lawyers say the draft rules don’t provide a clear definition of what constitutes “control” of a company. Other lawyers and industry experts point to companies with shareholding or other arrangements that keep voting power in the hands of their Chinese founders as examples of companies likely to be seen as Chinese-controlled. This raises the question of whether every Chinese company with foreign investment needs to have a system that ensures that their Chinese executives have more power than foreign investors. Some lawyers say the draft rules could be a double-edged sword for foreign shareholders of Chinese companies. While the new rules may ease the restriction on foreign ownership, they could also pressure Chinese companies with foreign investors to adopt structures such as dual-class shares to ensure that their Chinese founders and executives will effectively have more voting power than foreign investors.
What effect could the new rules have on companies?

The draft rules are still preliminary, and they could change before becoming law. It’s also unclear how they’ll be implemented, so it’s hard to say for sure how they’ll affect existing companies that use VIEs, like Alibaba and Tencent. Wenfeng Li, a counsel at Weil, Gotshal & Manges LLP, says the proposed rules could help to reduce uncertainties for companies that use VIEs – virtually every Chinese tech company listed in New York – since it has been unclear what the legal status of a VIE is, or what rights foreign investors ultimately have over the operating company. The Junhe Law Firm in Beijing says in a report that companies with a VIE structure that are deemed to be under Chinese control may consider getting rid of the structure entirely and have their Chinese founders directly hold the companies. Maintaining VIE structures can be costly, according to some lawyers. If a VIE is deemed to be under foreign control, could they still negotiate with government agencies for the right to operate in restricted sectors, and would there be a transparent process for doing that?
Who are the winners and losers?

According to Mr. Gillis, as well as attorney Wenfeng Li of Weil, Gotshal & Manges, winners could be Alibaba, Baidu and other companies that have dual-class share structures or other similar arrangements that appear to keep their Chinese founders in control. Marcia Ellis and Gordon Milner of law firm Morrison & Foerster also say the new rules could help companies like Alibaba and Baidu make acquisitions of Chinese companies more easily. Some say multinationals that use a VIE structure stand to lose because they would likely not be able to show that Chinese individuals or entities have “actual control” over their businesses in China. Alibaba has said it would comply with Chinese regulations while Baidu has declined comment.
What are the next steps?

The draft legislation is open for public comment. It would likely require the approval of the plenary session of the National People’s Congress expected to convene in March 2015. That means it could come into effect in the first half of 2016, according to lawyers at Weil, Gotshal & Manges LLP.

Guest Speaker Mr. Hemant Amin, Founder, Chairman and CEO of Asiamin Capital, a single family office, and Founder and Chairman of the BRKets investor groupMarch 17th, 2015

Hemant, a big thank you for educating and inspiring the next generation of leaders. You are a rare positive role model in the Asian capital markets and you showed the students that it is possible to create value because one has the right values and mindset like Buffett and Munger! :)